Pump Price Truths: Gas Won’t be Getting Cheaper, and That’s Okay

As a professional energy economist I am obligated to set the record on gas prices straight. This week I’ve heard that President Obama is to blame for higher gasoline prices. I have heard politicians claim they can lower gasoline prices. A noted MSNBC announcer that covers the stock market pronounced that removing oil industry subsidies would raise gasoline prices.

Here’s the economic truth:

TRUTH: Price = Supply and Demand Gasoline stations adding a mark up to supply costs do NOT set prices. Prices are established by the market dynamic of consumer demand and manufacturing supply. The price of oil is high right now because incremental world demand is growing faster than the marginal capacity for increasing oil supplies.

TRUTH: Gasoline prices will NOT come down Because it is supply and demand that sets the price of gasoline, the price of gasoline will not fall over the long term. Does anyone really think the price of gasoline will be less in 5 years?

There are two mega-trend reasons why the long term price for gasoline will be higher: The first is that there are no more “Saudi Arabias.” That means the world no longer has an easy-to-recover, low cost, low risk new pool of oil to harvest. There is still a lot of oil to be recovered but it costs more to do so because of very high risks and costs tied to geopolitical issues and the high potential for causing environmental damage associated with new deposits of oil. The only scenarios where pump prices could fall are a global economic collapse or breakthroughs in biofuel technologies.

The second more telling reason why prices will rise over the long term is that world demand for oil is growing faster than incremental new supplies can be delivered. The world is adding a new middle class over the next 20 years that will have a buying power equal to 1.5 times the current U.S. annual Gross Domestic Production. In economics this is called the “Income Effect.” This new middle class is expected to buy more oil even at higher prices because their incomes are higher.

FALSE: “Drill Baby Drill” will lower pump prices I know of no oil industry executive who thinks there is so much lower cost, lower risk oil still to be discovered that it will lower the price of oil in the face of the world’s growing incomes and the use of this income to buy more gasoline, diesel, plastic bags, fertilizer, etc. More supply may reduce the pace of price increases. It will not lower prices.

FALSE: Government oil production subsidies keep gasoline prices lower The incentive to find more oil is tied to how much money an oil supplier can make selling their oil. The value of an oil company’s stock is based upon how much oil it has in reserves, its ability to find more oil and the market price of oil. Government subsidies are much too low compared to today’s overall value creation realized from finding commercially deliverable oil for their removal (or increase) to impact the incentive for oil companies to find and deliver more oil.

What has changed in the oil & gas industry’s pursuit of oil is oil’s higher price. At today’s price we are seeing an explosion in hydraulic fracking drilling for gas (and the refining of Canadian oil sands). Fracking is not a new technology though there have been, and continue to be, technology improvements. What is new is the higher price of oil that makes this technology economically attractive for finding more oil and natural gas. Proof of point is the current $2.50-2.75 price range per MMBTU for natural gas that is 50 percent lower than just a couple of years ago. This lower price was realized by the increased commercial use of hydraulic fracking that has generated such an abundance of supply that natural gas suppliers are now curtailing production to support natural gas prices from falling further. Why oil is not seeing a similar price decline, is because the world demand for oil is so strong compared to incremental supply capacity plus the geopolitical risk of the curtailment of current supplies.

FALSE: Politicians can lower gasoline prices That is only partially true. There is a lot of tax placed on gasoline at the pump. So politicians could eliminate this tax and the price at the pump would be less until this lower price sparked increased consumer demand against a static supply. The ultimate result will be the price of gasoline pushing back up at the pump.

The real price responsibility of the political system is to reflect a true cost at the pump (or meter and cash register) that includes social and environmental externality costs. The current political system includes the military cost of protecting oil supplies as a part of income taxes. Why? Economic efficiency (this is a term used by economist to describe when consumers make informed decisions) is gained if this cost is reflected at the pump. This same economic sense applies to the health cost impacts of gasoline and diesel tailpipe emissions (and the stacks at coal fired power plants). Currently these are reflected in health care premiums and Medicare taxes. What politicians should do is shift the societal and health cost impacts of burning fossil fuels from income taxes to the pump (and meter) thus enabling consumers to make better informed decisions for the economy and their health by revealing the comparative value of options like hybrid cars, electric cars, mass transit, living near work, bicycling paths, solar supplied recharging stations, cloud based retail shopping, etc.

FALSE: High gasoline prices damage the economy Read this twice: The U.S. economy is growing with a decline in gasoline consumption.

Gasoline consumption is at a nine-year low. A major reason is that new car fleet mileage is up 14 percent in just four years. (Yes, there is a spike in consumption this week. The reason appears to be consumers attempting to beat future price increases by topping off their gasoline tanks.)

Over the short term, because America still has a huge inventory of low MPG gasoline-powered cars, higher gasoline prices will have a negative impact upon economic growth because consumers will have less money to spend on other products that can generate jobs and economic growth. The key point is this is short term.

In fact the U.S. economy is rebounding as consumers and businesses adopt sustainable economic decisions. They are buying more energy efficient cars and trucks. The Millennial Generation is shifting from their parents’ suburban lifestyles to living closer to their work. With manufacturing economics of scale the per unit cost of cleaner technology cars and trucks is gaining retail price competitiveness. That is the foundation of my projection that in 2011 a world economy of sustainable goods and services achieved a $1 Trillion annual revenue tipping point. Further, we forecast that by 2010 the global annual revenues of sustainable goods and services will reach $10 trillion representing 20 percent of the world’s annual commerce.

The final pump price truths are:

1) Gasoline is a 20th century solution that is losing its price competitiveness to energy efficiency and cleaner technology solutions.

2) No politician can lower the world price of oil.

3) Oil companies are not creating higher oil prices. Believe me, at today’s prices they are trying as hard as they can to find more oil. And they are very concerned that higher gasoline prices will permanently erode U.S. demand for oil. But oil prices will not fall over the long term because the ability of oil companies to increase supply lags the incremental increases in the world’s consumer demand.

4) High long-term oil and gasoline prices are not a product of speculative trading. Corrupt trading could cause price volatility and spikes. But the underlying cause for higher prices is that incremental demand is growing faster than the marginal capacity of production.

As painful as pump prices are this is great news over the long term for America, the environment and our economy. Price competitive sustainable product solutions are emerging. The ramification of sustainable products gaining price parity is that 85 percent of consumers will buy the more sustainable product vs. the less sustainable product if their prices are equal. Counter-intuitively, today’s higher price for gasoline is accelerating our economy’s potential for implementing sustainable solutions that will create American manufacturing jobs and restore our environment.

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Bill Roth is the founder of Earth 2017. His book, The Secret Green Sauce, profiles case studies of business best practices for making money going green. As the Green Business Coach for the U.S. Hispanic Chamber of Commerce Foundation’s Green Builds Business program sponsored by Walmart Bill has coached hundreds of business owners on best practices that make money and a difference.

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I totally agree. It is so obvious that it should not need to be stated. But history is replete with records of socities that collapsed while in a state of denial.

The big players in the industry understand reality. It is our “leadership” that appears to be clueless.

Nicholas Palmer

I admire your optimism, Mr Roth. The efficient market mechanisms you describe depend on the almost unspoken assumption by economists that fully informed consumers will make fully rational choices.

Unfortunately, your country has hugely expanded lobbyists, psychological marketing and advertising methods over the last 60 years and they effectively render many choices made by the mass of the public to be as informed, rational and independent as those of someone acting under post-hypnotic suggestion.

http://www.earth2017.com/ Bill Roth

Thank you Daniel and Nicholas for your comments. The United States still doesn’t have a national energy policy in large part because of the lobbying power of corporations with an invested interest in the status quo. But most importantly the United States does have a free market with very astute and experienced consumers. That is why we have Apple, Google, Twitter, et. al. Our consumers will change on a dime, literally. And that is my economic source of optimism. Consumers will not suffer pain at the pump, meter or cash register. They will find a solution. And that solution working its way into the American economy is Sustainability! For all the financial talk about economic stimulus it is my micro-economic observation that it is U.S. consumers and companies adopting sustainable best practices that is re-sparking our economic growth. It will be the U.S. free market that leads the world into a 21st Century Sustainable Economy.

Mary Solecki

Mr. Roth, I see your point about there still being adequate incentive to extract and refine oil, with or without subsidy. However, wouldn’t the cost of the lost subsidy be passed on to a consumer, therefore raising the price of gasoline? (At least, before lowered demand would drop the price down again). It seems as if eliminating oil subsidies AND some fuel taxes would result in a net zero effect to government revenue and consumer prices. Plus, this would have fantastic appeal to conservatives.

Thank you for your article. Very informative. It seems so straightforward when phrased like this, but so much more complex in practice.

http://www.earth2017.com/ Bill Roth

Really good question. Thank you Mary. Costs do not singularly determine price.

Price in a free market is determined by the intersections of supply and demand. If subsidies reduced supply compared to demand then yes, prices would go up. But the supply of oil is not being pushed by subsidies. It is being pushed by the high price for oil. At today’s $100+ price for oil a gusher (sorry for the pun) of new technologies and hydrocarbon deposits are being brought into the supply chain. Even with this new supply the price of oil continues to rise because the rate of demand increase is greater than the rate supply increase. And the price continues to trade higher as the market factors in risks like a nuclear-armed Iran or a BP oil spill.So what happens if subsidies go away? Again, in today’s oil market subsidies are linked to oil company profitability, not to oil prices. The size of the subsidies won’t change the supply of oil. Demand won’t change. What will change is how much an oil company receives from a government.Thank you for reading my article. Hope this further explanation helps.

Carl Jones

Hi Bill, I agree completely about the economics and the desirability of stimulating sustainable energy sources. A side note I used to work in the oil industry, and within the industry, the technology is usually referred to as hydraulic fracturing, and if shortened is spelled frac, as in “engineered frac fluid” or “frac job”.

http://www.earth2017.com/ Bill Roth

Thanks Carl for the terminology help. This technology is truly disruptive. It has positioned natural gas as a cleaner, price competitive alternative to coal.

It can be a threat to water supplies if available technology solutions and responsible drilling protocols are not adopted. Will consumers/voters be confronted with choosing between water and energy? This technology opens the door to micro-grids combining natural gas supplied fuel cells, renewable energy, energy efficiency and smart technology systems that will challenge the traditional utility system (or more likely, revalue the utility system based upon its ability to act as always-on battery and load balancing trading platform).

Mr Roth, Speculators have a large impact to the price at the pump. Many economists say it might even be as high as 40%. You however totally leave this out of your analysis and simply talk about supply and demand.

Can you kindly explain? It would seem as if the impending legislation being blocked / watered down to regulate hedging in this space will ultimately lower prices at the pump when enacted. All without any change to supply (which is up) or demand (which is down).

As a result gas prices are artificially high and politicians CAN lower them simply through regulation.

http://www.earth2017.com/ Bill Roth

Great question on speculative trading, regulation and oil prices. Thanks.

There is a need for regulation when speculative trading is impairing a free market (vs. commodity trading which has a legitimate role in a market enabling the management of price and supply risks for suppliers and buyers). A key government role is to aggressively audit for price manipulation. It has surprised me not to hear politicians requesting an audit of the refinery industry to explore for any “Enron-like” constriction of supply due to “maintenance” or closing of “aging plants.” The industry should welcome such an audit.

But there is a major distinction between government efforts to stop unfair price manipulation and regulating prices. Being an older bald economist has one advantage, you get to see what has worked and what doesn’t. Regulating a free market to control prices has not worked in my life time.

Oil is a global commodity. If the US government unilaterally sets a lower price for oil sold in the US to relieve pain at the pump then oil suppliers will shift their sales to someone else willing to pay the market price. That is how it works when incremental demand exceeds incremental supply. One alternative to higher pump prices is lines at the pump trying to buy fuel limited in its supply by an artificially low government imposed price.

Kym

I am terribly impressed by the simple yet brilliant overview you provide here and have shared it on all my feeds. My hope is that people will take the time to read and understand vs. our current culture of moving on sound bites, which in this case impacts the election. So while I agree 100% with you on why this is a good thing for our country and the planet, near term it has potential to move the election and that speaks volumes about our country and why we don’t have more hybrids and electrics on the road ahead to these high prices. When I bought my hybrid in ’07 people didn’t understand because of the cost/benefit ratio (wasn’t there then). Same with the solar panels on my roof. And, I live in California! Thus, anything that balances out the need for a cost justification is a good thing, true!

http://www.earth2017.com/ Bill Roth

Kym, you are America’s future driving a hybrid with solar on your home. Bless you!!

As an economist here’s the good news, the price of “unsustainability” is going up. The price of sustainable goods and services are coming down. People are starting to figure this out. The majority of Americans now buy organic food. No, not all their purchases are organic but compared to just a few years ago the idea that every week the majority of Americans put organic food into their shopping carts is a real breakthrough. Yes, they complain about its higher price but the competition between Whole Foods and Traders Joe is driving these prices down. Now Walmart has just launched their Good For You label. People are making the connection at the pump, meter and cash register that sustainability offers real value in terms of human, economic and planet health.

I am not a politician (thank goodness) but you are right on target. High gas prices could impact the election. I sense (I pray I am right on this) that people are figuring out that more pipelines and “drill baby drill” hasn’t lowered pump prices since the 1974 oil embargo and they won’t in the future. When a Presidential candidate promises $2.50 gasoline does anyone really believe them?

The typical use of the word “brilliant” when referring to me has to do with the glare off my forehead. Thank you for your kinds words!

Bill

TedKidd

Fantastic Post. Selling the idea of higher energy cost is a serious challenge, we need to support Bill in his quest to educate the value of this perspective to all Americans.

http://www.earth2017.com/ Bill Roth

Thanks Ted for the kind words. We are at a cross roads as an economy and country. 600 Volt owners report that they are averaging over 120 MPG! We can follow their lead and invest in clean tech as a solution. Or “drill baby drill” and continue to link our economy to the price at the pump.

It is reported that today California is using Brazil sugar cane ethanol at $0.16 per gal increase over using GMO corn fuel ethanol. In this game the cars and trucks get to pay and Big oil profits are the result that may be ready for change.

We do NOT support AB 523 or SB 1396 unless the ethanol mandate is changed to voluntary ethanol in our gas.

Folks that pay more at the pump for less from Cars, trucks, food, water & air need better, it is time.

The car tax of AB 118 Nunez is just a simple Big oil welfare program, AAA questioned the policy and some folks still agree.

AB 523 & SB 1326 are just a short put (waiver) from better results.

GOOGLE: Prop 87 (510) 537-1796

john elway

“That is the foundation of my projection that in 2011 a world economy of sustainable goods and services achieved a $1 Trillion annual revenue tipping point. Further, we forecast that by 2010″

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